How to Use a Dynamic Equity Split Program So Everyone Gets What They Deserve

While there hasn’t been much written about dynamic equity splits they are hands down the most fair way to divide up shares in a start-up company among founders, early employees, partners and anyone else that deserves a slice of the pie. A fixed equity model, no matter how thoughtful and well-intended, is guaranteed to treat one or more people unfairly. A dynamic model, on the other hand, will allow you to determine exactly the right number of shares each person deserves based on (and here is the key) therelative value of their individual inputs. I believe a dynamic equity split will soon become the de facto standard of splitting equity in bootstrapped companies with fair leaders (that’s my goal).

In a dynamic equity model, for instance, the founder or founders who provide 90% of the great ideas, early seed money, sweat equity and other resources will wind up with 90% of the reward and the junior developer who provides only 2% of the great ideas, early seed money, sweat equity and other resources relative to the founders will receive 2% of the reward. This is how it should be; anyone who thinks differently is probably someone who wants more than their fair share. (This is quite common and don’t feel bad if it’s you. All it means is that you don’t yet understand the power of dynamic equity splits.)

Here’s how a dynamic equity spilt model works:

Step One: Have a trustworthy leader

Don’t join a start-up company unless you can trust the other people, especially the leader. The leader will control 100% of the equity while a dynamic model is being used. This means that an unscrupulous leader can take advantage of everyone. The leader is responsible for tracking the shares and keeping things fair. He or she will provide the appropriate cap table to the lawyers who create the formal equity agreement when the time is right. The right time to issue the equity is when the company shows real, actual, concrete evidence of value.

Step Two: Assign a relative value to the various inputs provided by each participant

A relative value is not the same thing as an actual value. Actual values in a pre-money start-up company are pretty much impossible to determine. Relative values are much easier to calculate and much more meaningful. The key is to set a relative value that is fair given someone’s background, experience and job responsibilities. For instance, the sweat of an experienced CEO with a couple of homeruns under her belt is relatively more valuable than that of an entry-level graphic designer. However, two founders with similar skill-levels may have a similar value to the firm.

When it comes to the value of someone’s time the relative value should not only take into account their skills and experience, but also the requirements of the job. You should be sure to subtract any current compensation the person receives in cash. Equity compensation is provided in exchange for what people put at risk in a new company. If you pay them a fair salary you shouldn’t have to give them any equity because they aren’t risking anything.

Time isn’t the only input an individual can provide. Other inputs include cash, loans, ideas, intellectual property, important resources (like equipment and supplies), strategic relationships and even things like office space. Nearly everything in a start-up company that can’t be bought with cash (if you don’t have it) can be acquired with equity. A dynamic model will tell you exactly how much each is worth relative to other inputs. Everything has a relative value that is fair to the provider and the other participants. Over time these relative values really add up. I’ve posted a summary of how to calculate relative values here.

Step Three: Calculate shares by dividing an individual’s contribution to the company by the total contribution (individual value ÷ total = shares %)

This will give you exactly the percentage of equity a person deserves. No more and no less. I call the total contributions to the firm a “Theoretical Base Value” or TBV. It’s theoretical because it’s not real. It simply adds up the values of the inputs based on the value you assigned in step two. So, you may determine that a founder is “worth” $200 per hour. But, if he works 1,000 hours the company may not actually be worth $200,000 more. I hope it’s worth a lot more than that, but the point is that the value of inputs are only important as a relative measure. I’ve posted a calculator spreadsheet here.

This means that over time the potential equity split will change depending on what someone contributes. This is why it’s called a dynamicsplit. When you get a major investor or start generating enough cash flow to pay people you can calculate the equity, issue official shares, sign a shareholders agreement and be on your way. So, the sooner you raise money or the sooner you make money the sooner you can “lock in” the equity.

Dynamic equity splits make no assumptions about the future value of a company. It doesn’t matter what the future value will be. All that matters is that when you actually create future value everyone who risked something to help you get there should get their fair share of what’s created. Only a dynamic equity split can achieve this. Only a dynamic equity split provides a framework of fairness and respect for all participants. All other methods are prone to failure in their ability to treat people fairly. When I say “all others” I mean all others and “others” is what is commonly used today. That means the model you used or are planning to use in your start-up is putting you and your team at risk of unfair equity allocation. Sorry! (It’s not your fault!)

Dynamic equity splits are very uncommon, however, because the process isn’t well understood. Additionally, the dynamic nature of the split scares people who want to grab the biggest possible piece for themselves. Even the founder who errs on the side of generosity will ultimately fail because they, themselves, will be treated unfairly. When you think rationally about the dynamic split you will begin to recognize it’s inherent fairness and elegant simplcity.

I’m on a personal mission to make sure that every entrepreneur on the planet understands dynamic equity models before they make the horrible, but common, mistake of using a traditional fixed model. Too many start-up companies are destroyed due to conflicts that arise when people on the team are treated unfairly. The dynamic model can accommodate all possible outcomes in a way that motivates and inspires a person who is treated with fairness.

Who decides what the relative values of each person’s contributions are? It is clear enough that they could be decided at the outset, by agreement, or there is no company (i.e. if someone doesn’t like the relative split that the others are proposing, then they can simply decide not to get involved in the start-up, before they have risked any of their time or other resources. That does not of course work beyond the inception of the company. Say after three months someone has contributed significantly more, or less, than their previously assigned equity split, who decides whether they in fact actually did more or less than their share and what the new splits should be? Are relative values reassigned periodically, say quarterly, at certain milestones or when there has been a substantial change in relative contributions (and who determines that)?

When someone contributes to a startup company and does not get paid, they are essentially “betting” that contribution on the future outcome of the company. The value of that bet is equal to the fair market value of the contribution. The fair market value of your time, for instance, is the salary you would otherwise be paid by someone else.

Thanks for the post. What are the ways to legally and contractually protect against the risk of trusting one leader with 100%? Are there some common contractual arrangements that say this leader is holding the stock in trust?

Hi, I’ve read your book and have a question concerning contributions. If we want to create a “startup” company doing digital printing with me and a partner on board. First we will invest in equipment which has monthly loan payment and basic staff which i am the funder and the partner mainly find customers and run the show. The question is if I am already in large scale publisher of books etc (as another company) and can move some work from there to this “startup” right away and also establish credit line for paper/supplies on day one based on the credit of my existing company – how should this be calculated as a contribution. The volume of the work is significant to payoff the machines’ loan right off (keep them running) as they print out books for the existing company (and my company then pay the “startup”) and so makes this venture almost “risk free” in terms of finances- if the partner finds clients (which they sure will) that money immediately becomes profit. (less staff salary etc which is not substantial since that is minimal initally)
I understand that the slicing pie model is based on cash strapped beginning – once the business can pay for itself then the pie freezes. But in this case since this “startup” is taking reasonable cue from my existing business and literally get a jump start to the point that the company right away can certainly support itself (I may make some money contribution but minimally to support any shortfall), how should I offer fair equity for the partner who is just a willing soul to work with me (but no money) while I mainly help by providing leverage from my existing business in described nature which is substantial as it saves the “startup” tonnes of time scrambling to make ends meet initially. Thanks

If you are immediately able to pay all your bills with cash flow you don’t need Slicing Pie. Slicing Pie is only used during bootstrapping.

With a cash flow positive company you can get a 409A Valuation report (http://to.capshare.com/409a) and create a stock or options plan. Your partner can buy into the plan with all or part of his or her salary,

Hi Mike, thanks for sharing. Can I ask a question? If there are 2 Founders, A and B. What if Founder A is initially working full-time for the business and in later stage he decides to work part time and he may go absent for a few weeks. How do you calculate his part time and absence scenarios in order to be fair to Founder B. Please advice. Thank you.

Slicing Pie is ideal for this situation. The model is based on the fair market value of the actual inputs made by each contributor. It uses a fictional unit, called a “Slice” to account for these inputs. A person’s share is their slices/all slices upon termination of the model at breakeven or Series A. If inputs go down or stop, the number of slices a person is accumulating also goes down or stops. So, A is accumulating fewer slices. If A is not doing his or her job, he or she may get fired and, therefore, lose all or part of their slices.

This situation is exactly what Slicing Pie is for. It’s all covered in The Slicing Pie Handbook: http://amzn.to/2vE5qrB

Alok

we are starting a new business. Total of 8 founding partners. There is a clear distinction between seniority of various people
(tier 1 : 3 people (partners),
tier 2: 3 people and
tier 3: 2 people).
Right now the we are discussing the equity split as static tier 1, 25% each, tier 2: 10% each and tier 3: (4% + 3%) )
I feel like people in tier 3 are not getting compensated fairly and they should be rewarded more. We are planning to split the profits by the equity share.
What I proposed to the team is that the profit share is variable and depends on the absolute value of the profits. For example, for small profit ($100,000) the bonus split is in the same ratio as above but as the profit increases.. ( say large profit of $1,000,000), the share of tier 1 people reduces to 20% and share of tier to increases to 15% tier 3 people will increase to approx 10%.) My idea behind this is that smaller percentage of small amount will not matter, but for a large amount tier 1 getting 7x of a very large amount compared to tier 3 doesn’t seem fair to me.
Is this something people have discussed before? A linear variable in the profit split depending on the absolute value of the profit. What are your thoughts on this?

Don’t do this. It will backfire. Use the Slicing Pie model as explained in The Slicing Pie Handbook (http://amzn.to/2yEUnOk). Differences in seniority will be reflected in each person’s fair market salary. “Profits” is a tricky concept because you will only be profitable after breakeven which implies you will also be paying salaries. In Slicing Pie you can easily distribute lump sum payments of cash as it becomes available.

Slicing Pie will solve 100% of this problem. What you are describing will definitely not work even if you can get people to agree to it.

If you want to talk in detail about how to do this you can set up a call with me here: clarity.fm/mikemoyer

-Miike

Alok

I just bought the book. Will explore in next few days. I belong to Tier 3. If there is a large profit, then i dont want tier 1 guys to make 6.5x of my share. That will be way too much and not fair. I want to increase my bonus share if there is a large pie to slice… (increase relatively). For small size pie, i dont mind smaller share.
I guess it will take few days for me to finish the book. If you want to discuss it before that, I am more than happy to contact.

Startups include people with many different levels of commitment. Those who work fewer hours will get fewer slices than those working more hours as long as they have the same fair market value. In Slicing Pie, you can track by hours by week or any other way you want. If you’re using hours you’ll get a more accurate record of how many hours someone is working and give them pie to reflect their work. If someone is working 80 hours per week, for instance, they would actually earn 4000 hour’s worth of slices in a year. If someone is working part-time, it would be unlikely that they would exceed 2000 hours.

If you’re dealing with employee who qualifies for overtime payments you will have to add additional hours to compensate them. There is no built-in function for the Pie Slicer.